Interactions between loan-loss provisioning regimes and business cycle fluctuations are studied in a dynamic stochastic general equilibrium model with credit market imperfections. With a specific provisioning system, provisions are triggered by past due payments. With a dynamic system, both past due payments and expected losses over the whole business cycle are accounted for, and provisions are smoothed over the cycle. Numerical experiments with a parameterized version of the model show that a dynamic provisioning regime can be highly effective in mitigating procyclicality of the financial system. The results also indicate that the combination of a credit gap-augmented Taylor rule and a dynamic provisioning system with full smoothing may be the most effective way to mitigate real and financial volatility associated with financial shocks.

We study the macroprudential roles of bank capital regulation and monetary policy in a borrowing cost channel model with endogenous …nancial frictions, driven by credit risk, bank losses and bank capital costs. These frictions induce …nancial accelerator mechanisms and motivate the examination of a macroprudential toolkit. Following credit shocks, countercyclical regulation is more e¤ective than monetary policy in promoting price, …nancial and macroeconomic stability. For supply shocks, combining macroprudential regulation with a stronger anti-in ‡ationary policy stance is optimal. The …ndings emphasize the importance of the Basel III accords in alleviating the output-in ‡ation trade-o¤ faced by central banks, and cast doubt on the desirability of conventional (and unconventional) Taylor rules during periods of …nancial distress. JEL Classi…cation Numbers: E32, E44, E52, E58, G28We are grateful to the Editor and two anonymous Referees for very helpful comments on a previous draft. We are also thankful to 2 full. At the same time, credit risk induces further bank capital losses, resulting in an increase in the cost of bank capital as well as stricter regulatory requirements (under Basel II), both of which lead to higher borrowing costs. As in Ravenna and Walsh (2006) and De Fiore and Tristani (2013), …rms in this setup must borrow from commercial banks to …nance their labour costs. Therefore, the re…nance rate, bank capital regulation and the various credit market frictions described above (all of which endogenously impact the lending rate and …nancial market conditions) translate also into changes in the behaviour of the marginal cost, price in ‡ation, wage in ‡ation and output through the borrowing cost channel. 3 Building on this literature, the borrowing cost channel in our model is enhanced by a richer banking environment, regulatory requirements and various credit frictions, which can explain important links between the …nancial sector, in ‡ation and the real business cycle. 4 Compared to the majority of the macro…nance literature, where credit lines are used to …nance house purchase and investment in physical capital, we pursue a di¤erent approach and indeed introduce loans to …nance labour costs. This modeling viewpoint is motivated by recent evidence which suggests that variations in working-capital loans following adverse …nancial shocks can have persistent negative e¤ects on the economic activity (see Fernandez-Corugedo, McMahon, Millard and Rachel (2011) who estimate the cost channel for the U.K. economy and Christiano, Eichenbaum and Trabandt (2015) who estimate this channel for the U.S.). This result, therefore, requires the examination of macroprudential policies when …rms rely on external …nance to support their production activities.The simulated model shows that countercyclical …nancial regulation (Basel III) is very e¤ective at fostering …nancial and price stability, whereas credit spread-augmented Taylor rules increase price and wage in ‡ation volatilities, and thus provide zero welfare gains. ...

We study the macroprudential roles of bank capital regulation and monetary policy in a borrowing cost channel model with endogenous …nancial frictions, driven by credit risk, bank losses and bank capital costs. These frictions induce …nancial accelerator mechanisms and motivate the examination of a macroprudential toolkit. Following credit shocks, countercyclical regulation is more e¤ective than monetary policy in promoting price, …nancial and macroeconomic stability. For supply shocks, combining macroprudential regulation with a stronger anti-in ‡ationary policy stance is optimal. The …ndings emphasize the importance of the Basel III accords in alleviating the output-in ‡ation trade-o¤ faced by central banks, and cast doubt on the desirability of conventional (and unconventional) Taylor rules during periods of …nancial distress.

The global …nancial crisis in 2007 prompted policy makers to introduce a combination of bank regulation and macroprudential policies, including non-conventional monetary policies, such as interest on reserves and changes in required reserves. JEL Classi…cation Numbers: E31, E32, E44, E52, E50, G28

as well as participants at the Lancaster University Macroeconomic Workshop and at the Computing in Economics and Finance (CEF) 2022 conference for discussions, comments, and suggestions.